Risk assessment

Tourism and household consumption serving as drivers of growth

After an exceptional year in 2016, economic activity is expected to slow in 2017. Nevertheless, growth is expected to be sustained by strong household consumption and tourism. Additionally, investment is expected to remain high in key sectors of the economy.

Indeed, private sector consumption is expected to remain the driver of economic growth in Iceland thanks to a strong increase in real wages in 2016 and a low unemployment rate (3.2% in February 2017). The tourism sector is growing strongly and is expected to again positively contribute to economic activity due to the government's desire to increase investment in this sector. These investments would spur growth in the construction sector while further reducing unemployment. The fishing and aluminium sectors are also expected to see major investment and they should remain a significant portion of the economy. However, investment may begin to be hurt by the increase in wages if productivity increases less rapidly than real wages.

Inflationary pressure is expected to increase due to the increase in wages, which may be less and less compensated for by the decrease in import prices from appreciation of the Icelandic krona. Inflation is also expected to increase due to strong growth in domestic demand. As such, the central bank should remain careful, particularly as the elimination of capital controls could affect exchange rates and inflation. Increased volatility in exchange rates could threaten the stability of prices and require the central bank to intervene. The government may also consider pegging the Icelandic krona to the euro in order to limit the krona's volatility.

A slight budget surplus and liberalisation of the capital account

Iceland is expected to have a slight budget surplus in 2017 after 2016 was marked by exceptional revenues from an agreement to transfer assets from failing banks to the government. Public debt is expected to continue decreasing following budget tightening enacted in past years, as well as thanks to decreased debt servicing. The government is expected to continue its cautious budgetary policy in order to prevent the risk of overheating the economy. Increased tax revenues, brought by the strong economy, will thus likely be largely directed towards continuing to pay down the national debt and improving the efficiency of public services, rather than going towards increased expenditure.

The current account surplus is expected to remain at a comfortable level in 2017 thanks to a strong service sector, particularly with tourism, that should offset an increase in imports (driven by very strong household demand). Furthermore, exports of goods will likely continue to be hurt by appreciation of the krona, which has continued since 2015. Exports will also be hurt by the embargo by Russia (Iceland's fifth largest trading partner) enacted due to the position taken by Iceland in the conflict between Russia and Ukraine. However, sales of seafood and aluminium are expected to remain strong and should still represent around 75% of total exports.

The Icelandic Finance Ministry announced in mid-August 2016 the gradual lifting of capital controls established after the 2008 crisis. This liberalisation was completed in mid-March 2017 with the elimination of the last restrictions. The end of capital controls should send a positive signal to foreign investors without threatening the financial stability of the country, where interest rates are attractive and the main banks have strong levels of capital. Additionally, the central bank's large currency reserves should allow them to face any situation that may arise.

A new pro-European government

Following the revelation in the Panama Papers of his involvement in tax fraud, Prime Minister Gunnlaugsson (from the Progressive Party) resigned and was replaced by the former Minister for Fisheries and Agriculture, Sigurdur Johannsson, in April 2016. Legislative elections on 29 October 2016 came out with the Independence Party on top, without them gaining a majority (21 out of 63 seats). After three attempts to form a coalition, the Independence Party finally succeeded in forming a government in early 2017, in coalition with the Reform Party (Vidreisn) and Bright Future (BF). The coalition is led by Bjarni Benediktsson, the new Prime Minister, and has a pro-European strategy that could renew the debate on the country joining the EU.